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Tip
Sheet: Business, Law & Economics Tip sheets highlight timely news and events at Washington University in St. Louis. For more information on any of the stories below or for assistance in arranging interviews, please see the contact information listed with each story. For comments on the Business, Law & Economics news tips service, please contact the editor, Robert Batterson at (314) 935-5202 or batterson@olin.wustl.edu. Game theory sheds light on how companies capture value to boost the bottom line Media assistance: Robert Batterson - (314) 935-5202 Source: Glenn MacDonald - (314) 935-7768 Related: MacDonald's Web site Related: Download MacDonald's paper [St. Louis, Mo., March 2003] - Firms create value in a variety of ways. They might find new ways to produce their goods at lower cost or introduce revolutionary new goods or services. They might convert unused assets into profit-makers or press product differentiation to their competitive advantage. Glenn MacDonald, Ph.D., professor of economics at the Olin School of Business at Washington University in St. Louis, has drawn on fundamental concepts of coalitional game theory to identify those aspects of value creation and competition that guarantee, on their own, that a firm appropriates value.
"Suppose I invent the game of basketball, which is very valuable," says MacDonald, the John M. Olin Distinguished Professor of Economics and Strategy at the Washington University business school. "But it's not something I can patent. After I invent it, a lot of basketball players get rich, team owners get rich, consumers enjoy the game and I don't get anything out of it. I've created a lot of value in thinking up this new game, but the appropriation of it has been very small." Though the creation of value is considered a "kind of mysterious creative process" that can't be analyzed, MacDonald finds that many researchers have sought to determine how to appropriate or claim as much value as possible once it is created, how to maximize one's share of the earnings, either as income and dividends or appreciated stock prices. "There are many different frameworks that are concerned with that kind of advice," MacDonald notes. The problem, he says, is that these different frameworks "tend to agree in certain settings, disagree in others." MacDonald and colleague, Michael D. Ryall, Ph.D., assistant professor of economics and management at the University of Rochester's William E. Simon Graduate School of Business Administration, pondered the shortcomings of these theories in their recently co-authored paper, "How Do Value Creation and Competition Determine Whether a Firm Appropriates Value?" They argue, for example, that contrary to popular belief, ownership of assets that are non-imitable and productivity enhancing does not guarantee value appropriation. "The novelty in what we do," they write, "is simply to focus upon an individual firm and to characterize the competitive conditions under which it appropriates value." "We realized that there's a certain amount of value and the question is, what determines how it gets distributed among the players?" says MacDonald, who also directs Olin's Center for Research in Economics and Strategy. Hitting on that question led the two researchers to a kind of game theory known as coalitional games -- and a powerful new unified theory about appropriating value in the marketplace. Whereas game theory in general describes how intelligent players will interact to accomplish their purposes, coalitional game theory deals with situations in which players organize themselves into strategic groups or coalitions. It examines the possible coalitions and calculates the potential benefit each group might reap. Coalitional game theory was first developed in the 1950s but never caught on because it seemed "esoteric and strange," MacDonald says. "We realized that the theory was needed for this kind of strategy problem." The result is a thoroughly generalizable method to assess value, analyze the alternatives for its distribution, and maximize the share one receives. The theory is useful in any industry addressing this issue, says MacDonald. Furthermore, MacDonald's and Ryall's study and application of coalitional game theory to their own work further developed the existing literature on the foundations of strategy. "No one had ever really asked in a coalitional game what determines how much any one player gets out of this," MacDonald says. "Researchers had a very different set of research questions. So we were able to make a fundamental contribution to coalitional games and in the process we were able to provide this basic value creation/value appropriation framework for strategy research." Essentially, the MacDonald-Ryall theory breaks the problem down into three pieces. The first is discovering how much value is created. The second is to determine, by a complex series of mathematical calculations, how much of the value's distribution is dictated by the power of various coalitional alternatives. For example, are there varied options by which players can appropriate the created value? And will some of these options induce players to form their own separate coalitions? The third and final piece is simply negotiation among the remaining players. "We use the math to describe the power of the alternatives," MacDonald points out. "This is something you can calculate. It is absolutely quantifiable. Then what's left is negotiation." As an example, MacDonald cites a firm that had developed a valuable technology for which it had little use in its own enterprise. Should it auction the technology off to the highest bidder among six interested firms? Or should it strike a deal with one very entrepreneurial new company? Though at first the auction seemed the obvious answer, applying the detailed mathematical formulae of the MacDonald-Ryall framework demonstrated that the selling firm would maximize its value by focusing on and bargaining with the innovative new company. "By focusing on whether the firm must appropriate at least part of what is created, our results are robust in the sense that they do not depend upon any assumed structure of bargaining," MacDonald says. "Or, to put it slightly differently, we identify exactly those aspects of value creation and competition that guarantee, on their own, that the firm appropriates value." |
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